On April 18, 2017, the Wall Street Journal reported that IBM’s first quarter EPS came at $2.38 against analysts’ consensus of $2.35. A three penny consensus beat which should have exhilarated investors. Alas, the Journal reported: “IBM shares fell 3.9% in after-hours trading.” How can this be? Don’t consensus meets (hitting the analysts’ estimates) and beats (surpassing the estimate) matter? Not really! Except for the many uniformed investors who still waste money on trading on consensus hits and misses.
In my recent book (with Feng Gu) The End of Accounting… (Wiley, 2016, chapter 2) we show, for all stocks, that meeting the consensus estimate doesn’t trigger any share price change, on average, while beating the consensus will get you a “whopping” half-a-percent price increase. Missing the consensus, a “calamity” that some managers will even manipulate earnings to avoid, will drop the share price by an average of 1-1.5%—a normal, daily price change.
What’s going on here? Used to be that quarterly earnings announcements, like those being released these days, were a major event for investors. Indeed. But in the last 2-3 decades, due to accounting regulators’ sins of omission and commission, reported earnings lost much of their usefulness to investors. Essentially, earnings no longer reflect enterprise performance and the change in its value. Hence, the feeble relation between reported earnings, or consensus beats/misses, and share prices. We document and elaborate on this startling earnings’ fall from grace in the End of Accounting…
But my conversations with investors and analysts make clear that my message of “earnings’ relevance lost” falls on deaf ears. Analysts’ investment models still revolve around earnings and their forecasts, and many investors take seriously quarterly consensus beats and misses (managers too take those announcements seriously). The following is one more attempt to drive my message with facts.
Suppose I offer you the dream machine which will enable you at the beginning of each quarter to predict for sure all the companies that will meet or beat the consensus estimate upon the release of their earnings, after quarter end. No more need for elaborate models and spreadsheets to predict earnings, no need to waste time in earnings calls, or in meetings with executives. With this perfect forecaster you will now be able to buy three months ahead of the earnings release date the stocks of the consensus winners and sell them after the earnings release. How much money will you make from this investment model? I bet, you think, a fortune. Do I have a surprise for you.
The following figure (derived with Feng Gu) reports for every year (1986-2015) the average gain from a 3-month investment in the companies that will subsequently meet/beat analysts’ consensus. Amazingly, these gains are sharply falling: from 6% (annualized: 25%) abnormal (risk-adjusted) returns in 1989-91 to less than 2% currently. Note, these 2% gains are derived by a perfect foresight of all the companies that will meet/beat the consensus. Since this is impossible, you, with all your research and models will get only a tiny fraction of this gain, namely close to zero.
Sorry for the bad news, but these are facts. Basing investment decisions on earnings, or consensus estimates meets/beats, is no longer a useful strategy. Analysts’ insistence on still structuring investment models and securities analysis on earnings and their prediction is a major reason for the recent astounding finding that over the past 15 years (as well as for 5 and 10 years) index funds have soundly beaten the funds managed by experts and analysts. When will they learn?
Lesson for investors: Don’t pay much attention to earnings beating or missing the consensus. Focus instead on the changes in the real value drivers, such as new subscribers, customer acquisition costs, and churn (deactivation) rate for Internet, software, media, and telecom companies; policy renewals and the frequency and severity of claims for insurance companies; same-store-sales of retailers; capacity utilization of airlines; and development of the product pipeline (drugs under development) of pharma and biotech companies. These fundamentals signal future growth, in contrast with the historical, relevance-lost earnings.
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